The numbers some ETFs don't want you to see

*Investors new to ETFs can read our guide How to invest in exchange traded funds.

What is tracking difference?

Tracking difference is a figure all ETF providers try their best to minimise, but some managers do this much better than others.

But don't confuse tracking difference with tracking error (sometimes shown on an ETF's fact sheet), which most investors don't understand properly. Tracking error measures how much the difference in the index performance and the fund performance fluctuates over time. However, tracking error measurements can have no bearing on actual investor experience. For example, if an ETF missed its mark by 0.05 per cent day in, day out, the tracking error would be zero. But if that index had stayed flat for a year you would have lost out by 12 per cent. What most investors care about is long-term buy-and-hold returns, and for these investors tracking difference is the measure to watch.

Many ETF providers disclose tracking difference figures in their fact sheets, but not all of them are so transparent. Fresh Morningstar research reveals that ETFs are generally succeeding in reducing tracking difference, but there are some exceptions.

The largest single contributor to tracking difference is fees, with Morningstar research showing that charges account for over 50 per cent of tracking difference. Other sources of tracking difference include withholding tax, particularly in Europe, the costs of rebalancing the components to reflect the benchmark being tracked and cash received from dividends - known as 'cash drag'.

Another major contributor to tracking difference is the complexity of the market being tracked. For example, the FTSE 100 index is a very straightforward index to track, whereas the Emerging Markets index is very complex (it is spread across many time zones, there are different tax rules and many of the countries are illiquid and therefore difficult to buy and sell in.) These are factors that can often lead to large tracking differences. Peter Sleep, an ETF specialist at Seven Investment Management, says: "In general, the more esoteric the market, the greater the scope for tracking difference."

How do ETFs improve their tracking difference?

Some ETFs use indirect replication techniques to track their indices. Instead of buying the physical underlying stocks in the index, they synthetically replicate the performance of the index by using derivatives called swaps. These processes are complicated, but Manooj Mistry, London-based head of exchange traded products, EMEA, at Deutsche Asset & Wealth Management, explains: "The fund contracts Deutsche Bank's trading desk to 'deliver' the exact returns of the index as part of a swap agreement. That means in a lot of cases the performance of the fund is generally very precise, and can be calculated as the returns of the index minus the total expense ratio."

He added: "For some ETFs, the tracking can be made even more precise through certain 'performance enhancement' activities such as securities lending, which can generate revenues to offset some, or even all, of the management costs. In the case of our indirect replication ETFs, these activities are carried out by Deutsche Bank and the fund receives the benefit via the 'swap spread'. In this case, the fund itself isn't engaging in securities lending, so it is not exposed to the counterparty risk that comes with the activity."

However, the Morningstar research found that an ETF's replication methods (whether they are physically or synthetically replicated) has little correlation to their tracking difference.

Why do some ETFs have positive tracking differences?

If performance enhancement activity goes beyond cancelling out the management charge, then the fund will register slight outperformance. This is called positive tracking difference. The funds you want are the ones with the lowest tracking differences. The possibility of the fund generating positive tracking difference relates to the extent to which the fund can utilise performance enhancement activities.

How do I find out the tracking difference of a fund?

The first place you should look is the fund fact sheet, but unfortunately not all funds disclose tracking differences here. In fact, most choose to disclose either tracking error or tracking difference, according to which flatters them the most. And it's not always the latter, so be aware of this. However, new regulations introduced this year mean providers do have to include both tracking error and tracking difference in their annual report, which you can find on their websites. Hortense Bioy, director of European passive fund research at Morningstar, said: "Fact sheets are essentially marketing brochures and will include information that makes the fund look good. Most don't include tracking error and tracking difference data, but it's a good sign if they do, as it means they aren't hiding anything. Always check annual reports as well as fact sheets."

Tracking difference on FTSE 100 ETFs

Source: Lipper. *Figures to the end of 2012